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These Income Strategies Have Drawbacks

Vanguard's Fran Kinniry urges yield-seeking investors to use history as a guide and focus on total return instead of taking on equity and credit risk associated with popular income-producing strategies.

Christine Benz: Hi, I’m Christine Benz for Morningstar.com. I recently visited Vanguard where I sat down with Fran Kinniry, a principal in Vanguard’s Investment Strategy Group. We discussed the pitfalls associated with some of the strategies that fixed-income investors have been using lately.

Fran, thank you so much for being here.

Fran Kinniry: Thank you, Christine.

Benz: Investors who are using a strategic, buy-and-hold, rebalancing program probably look at their allocations and see that they're heavy on stocks, light on bonds relative to their targets. But investors do have some trepidation about taking from their equity holdings and adding to bonds at this point. What do you say to investors who are looking at their portfolios knowing they should rebalance but maybe are hesitating to pull the trigger and do it?

Kinniry: I think most investors always struggle with rebalancing because in the moment, real time, there is always a back story. Think back to 1999, there was the new paradigm, Dow 36,000. We all knew equity allocations went up pretty strongly, but very few investors were rebalancing then. We have to go back to think about how we were feeling at the end of 2008 or the beginning of 2009, when the stock market was just off 55%, and again, we saw very few investors rebalancing. Most of the flows were in bonds. And now again today we see the stock market up 185%. Everyone's expectations are that interest rates will rise. And so, it's hard to get people to take money off the equity side and put it into bonds. But history as a guide is really the prudent way to manage your asset allocation.

Benz: You mentioned, Fran, this interest-rate shock that everyone is expecting--and we did have a little bit of a taste of it back in the early summer where we saw rates shoot up quite a bit in a short period of time and certain fixed-income asset classes were hit pretty hard--but this, I think, is warning some investors off of bonds. So, not only are they hesitant to trim their equity holdings, but they're just not that excited about the prospects for bonds on a forward-looking basis.

Let's talk about the real risks for bonds. You recently did a research paper where you examined past bear markets for bonds and compared them with bear markets for equities. You found they're quite different animals.

Kinniry: Yes, not only in frequency. I think people may forget that the stock market has a negative return 25% of the time, one out of every four years. But the magnitude, how much you've lost in the stock market, is significantly different than the bond market.

You mentioned the early blip from May through the end of the summer; interest rates went up by 84 basis points, so almost a 1% increase in bond yields from a very low handle. That would rank as one of the biggest moves on an annual basis. Yet, the bond market at the time was only down 4% or 5%. A bear market in bonds tends to look like single digits, 4% to 8%, maybe 10% at the worst, whereas with a bear market in stocks, [we had] many episodes of negative 20%. And we just had two episodes within the last decade of down 40% and down 55%. So, the magnitude is significantly different, and we just want to make sure investors understand that.

Benz: What about people though who might ask how instructive past performance is in bonds given that we've had almost three decades worth of a generally declining rate environment?

Kinniry: I would say, first, everyone has to recalibrate themselves. The real return, which is the return over inflation on bonds has been anywhere between 2.0%-2.5%. And so, let's say inflation expectations as measured by Treasury Inflation-Protected Securities, or most expectations again are about 2%. Bonds aren't that far from their normalized return. If you take 2.0% to 2.5% of a real return, put that on top of inflation of 2.0% to 2.5%, normal bond yields are maybe 4.0% to 4.5% today. So let's play that out. Let's say we're at 3.0%, and we go to 4.5%. That's a 1.5% increase.

Duration on intermediate-term bonds, let's just use round numbers, is 5 years, so you'd lose 5%, and then add 2.5% to get 7.5%. But you have your coupon, your yield of, let's say, 3%. So your total return, we're right back to that 4.5% number.

Even if we forget the past and move forward, run interest-rate scenarios of where you think interest rates are going to go, multiply that by the duration, don't forget to add back in your yield, and you can see that it's hard to find too many environments where you would lose anywhere close to stock market-type losses.

Benz: Even though you don't have great gains coming from that appreciation as yields go down, you will actually have a decent total return.

Kinniry: That's right. And again, I think if you are a long-term investor, potentially one of the worst things you would have is interest rates stay low. Let's just say rates stay where they are and you have a 30-year horizon, you're going to collect, 2.5%, 2.5%, 2.5% for 30 years. If interest rates go up, let's say to 4.5%, you have a short-run hit to capital, but the break even of when that investor is actually better off in a nominal world is pretty short. That's because now, let's say, you lost 5%, but now you're collecting 4.5%, 4.5%, 4.5% instead of that 2.5%. You're picking up 2% a year, so you recapture that loss in about three years, and then for the next 27 years--again if your holding period is 30 years--you're collecting 2% more.

I wouldn't really be terrified of a rising-rate environment. I would make sure that your asset allocation is right: the stock-to-bond mix. And I think being in a low-return world, the things you can control are your savings and your costs of investment management; so try to keep those low as well given the low-return world.

Benz: We've seen investors taking a few different courses of action because they are fearful about rising rates. I'd like to cycle through some of them and get your take on the pros and cons of the different strategies investors are using. One--and we've certainly seen this loud and clear through Morningstar Asset Flows data--is that investors seem to be preferring credit-sensitive fixed-income types. We've seen big flows into bank loan or floating-rate funds, emerging markets bonds, certainly, and a few other categories. What's your take on investors who are gravitating toward those investment types because they like the income versus what they can get on high-quality bonds?

Kinniry: We really preach at Vanguard [to pursue] total return over income. And just to set up what that is, total return is keeping your asset allocation in accordance to your goals and objectives and time horizon and not really trying to engineer a yield. An income approach is trying to engineer yield, meaning that I want to spend 4% or 5%. Well, the total stock is yielding 2% and total bond is yielding 2%. So, what we do is we overweigh credit, as you mentioned, whether it be high yield, bank-loan notes, or emerging-markets debt. And I think what everyone has to understand, these are hybrid assets. When I say hybrid assets, even though they may have bond in the name, when the stock market performs poorly, they tend to rise in correlation. And so, if you think that those assets or going to protect you on the downside, we saw in 2008 and 2009 that was not the case.

So, we do worry today that investors have about the same amount of equity as they've had the last 20 years. Today, the equity allocation for U.S. investors is somewhere around 55% off of an average of 51%, but their bonds look tremendously different. First off, they have much less in money markets, and their bonds have a much more credit-sensitive nature to them, those I mentioned.

If we do have a bear market, which we're not saying that we will, but every one out of four years there is one, right, and now we're up 180%. So, I do worry investors look at their statements and they think they're 60-40 [allocated between stocks and bonds], but the 40% may not be high-quality, investment-grade municipals or high-quality, investment-grade taxable. They may have a much stronger equity beta to them. That's what we're seeing, and that really worries us.

Benz: One other related tack that we've seen people take is a very strong appetite for income-producing equities. I'm guessing you'll say it's part of the same story that investors should be careful about, supplanting fixed-income exposure with even high-quality, dividend-paying equities.

Kinniry: Absolutely. They're not even in the same ballpark. We just went through risk of loss of bonds, maybe single digits, in the global financial crisis. And Vanguard does have dividend-oriented equity funds. Those equity funds were actually off more than the S&P 500. Those were off between 55% and 60%. Dividend bonds, we're not saying good, bad and different, but they're certainly not a substitute for fixed-income investments, and we really caution everyone to move away from this income approach and go to the total return.

I tell most investors, do you know that a stock goes ex-dividend and a mutual fund that has stocks goes ex-dividend, meaning that the fund will drop dollar for a dollar when the dividend is paid? So, these dividend strategies and high-yielding bond strategies are a return of capital, because the next investor who wants to buy that is not getting that dividend. And so, it's actually a return of capital that's coming to you in the form of a dividend which is very tax-inefficient. You'd be much better off using a total-return approach and spend what you need to spend by selling assets when those assets need to be sold. It's more tax-efficient and it keeps the portfolio much less leveraged to one side of a trade, such as a dividend trade or a value-oriented process.

Benz: So, maybe use a rebalancing program to shake out the cash that you need from your portfolio rather than relying on it to be your sole income generator?

Kinniry: Yes, absolutely. I mean, first, most people that are taking income have to think about how do I get income to myself in the most tax efficient way. First and foremost, you have RMDs, which are required minimum distributions, that are forced upon you out of your tax-qualified account. That should go into a money market. That would be spent first as your income. Then you would have your dividends that you have just by nature, and the bond dividends, all into this what we would call spending account, money market. And if that is not enough, then you would go in and say, "I need to rebalance now. How do I rebalance while at the same time replenishing my spending account which is my money market account?"

To do all that, really adds a tremendous amount of value. If you do it well, it keeps your portfolio very diversified, not highly linked to one side of the trade. And it is the most tax-efficient way to generate an income stream.

Benz: The last strategy I wanted to touch on that we've seen investors embracing is this tendency to want to shield their portfolio from rising rates by shortening everything up, maybe even going to cash altogether. What's you take on that strategy? I'm thinking that you'll probably say there's an opportunity cost to doing that.

Kinniry: Yes, that's exactly right. I've been working with you for quite a while, Christine, and with the financial media in general, and we've been talking about rising interest rates really since 2000. What I'd tell investors is look at the yield curve, and the yield curve is basically what is the yield on a money market versus a short-term bond fund that has similar credit or an intermediate-term bond fund that has similar credit. And you're picking up somewhere between 1.5% and 3.0% by being in a short- to intermediate-term bond fund over a money market.

So, think about that, every year you're losing 1.5% to 2.0% in opportunity cost, and if you do that for three years, you've just lost 6%. So, I don't know if interest rates are going to rise. That's first and foremost. But if they do--how much do they rise, when do they rise, and what was the cost while you were waiting for them to rise--we've seen most people not do that very well.